In the past three decades, companies have steadily adopted the defined-contribution option, primarily in the form of 401(k) plans. The financial downturn has confirmed, however, that 401(k) plans fuel retirement patterns that run counter to business needs in a cyclical economy.
When economic growth is strong and employers need to retain workers, 401(k) account balances rise and employees are more likely to retire. When growth slows and employers need to trim headcount, 401(k) balances drop and workers are less likely to retire. An extensive 2008 study from the Wharton Pension Research Council confirms that plan participants significantly delay their retirement during the down phase of a business cycle.
Already-inadequate 401(k) account balances have taken a huge hit in the current downturn. For workers nearing retirement—those 56 to 65 with 21 to 30 years of job tenure—the average account balance fell 20 percent in the first 11 months of 2008, according to the Employee Benefit Research Institute. For some participants, accounts are down 30 to 40 percent.
Before the full depth of the downturn unfolded, Alan Glickstein, senior retirement consultant at Watson Wyatt Worldwide, had already warned employers about the latent risk in 401(k) plans, which leave companies with little control over who retires and when. With the financial crisis, this risk is no longer latent.
Employers now face two issues: the short-term problem of managing the workforce through a period when workers are unwilling to retire in a timely fashion, and the longer-term challenge of redesigning retirement plans to create better control over retirement patterns.
For employers operating outside the United States, mandatory retirement laws and government-sponsored pensions ease the challenges of managing a workforce through a downturn. Within the U.S., however, the next few years will pose a particularly sharp challenge.
In the short term, employers have two options. "The first is to simply deal with the fact that some employees will stay on longer than you want and determine what that means for employee morale, productivity, costs and career paths for younger employees," Glickstein says. "The second option is to create programs that encourage these older employees to fully or partially leave."
Glickstein believes more employers will offer retirement incentives, such as voluntary programs with a window for additional retirement benefits. "These programs need to be modeled economically, however, because they carry costs," he cautions. "Even in a more normal environment, the take-up rate is hard to predict and now it will be harder still. There’s a psychological fear factor among employees that is difficult to account for."
A phased retirement program could be part of the package, and Glickstein reports a tremendous rise in interest in these programs over the past year. "The objective is to manage workers out of the workforce in a fashion that carries lower risks for both the employer and the employee," he notes.
The ability to manage retirements may be further complicated by the rapidly growing trend to conserve cash by suspending the employer 401(k) matching contribution. A Watson Wyatt Worldwide survey found that 3 percent of employers eliminated their 401(k) match in the first 11 months of 2008 and 7 percent plan to eliminate it in 2009.
"What we are most concerned about is that actions taken during the crisis will reduce employees’ ability to retire and increase problems for employers," Glickstein says.
"Some employers have no choice, but employers who do should look at all the alternatives and what happens in the longer term to retirements and morale when you cut the match," he says. "These employers need to have more strategic discussions right now about their retirement plans and their future ability to manage the workforce."
Consequences of cuts
Five percent of midsize and large employers made cuts in their 401(k) match during the 2002 downturn, according to Pamela Hess, director of retirement research for Hewitt Associates. She believes that the portion of companies cutting their match could reach 5 percent in 2009 or 10 percent if the recession is particularly long and deep.
"A lot of companies are asking us about cutting their match because it is one of the easy big-dollar savings, and once some companies in an industry do it, it’s easy for others to follow," Hess says.
The cuts could last for two to three years or even four to five, but most companies will eventually reinstate the match, she believes. "That’s not altruistic—they want their employees to retire at some point," she says.
Eliminating the employer match carries a number of potential risks. Studies of 401(k) plans demonstrate that an employer match raises participation rates significantly and increases the employee contribution rate by almost 1 percent.
At some companies, eliminating the match may trigger nondiscrimination issues or eliminate safe harbors. "Employers may need to change vesting or tweak other elements of the plan to reduce the number of lower-paid employees who leave the plan or cut their savings rate," Hess says. "Reducing the match rather than eliminating it might be more palatable for employees. They may be more likely to stay the course."
The economic downturn may also end the trend toward automatic enrollment.
"Companies that might have adopted it will hold off because of the cost, and companies that might have pushed it out to their existing employees will also hold off," Hess says. "Opt-out rates are now 10 to 11 percent, but could go higher, especially at companies that have applied automatic enrollment to their existing employees."
According to Hewitt’s research, 4 percent of 401(k) participants dropped out of their plans in 2008—a surprisingly low rate, Hess says. If the more pessimistic economic forecasts are correct, however, the consequences for 401(k) plans could be dire.
"The system has never experienced a time when these plans are so important and the markets are so bad," Hess says. "Participation could drop by 20 to 30 percent.
"Employees who drop out of their plans may not get back in. People will not be able to retire, and tweaking a plan is not going to move older employees out of the company if they can’t afford to retire," she says.
Glickstein does not believe the current downturn will spell the end of defined-contribution plans, but he says that employers must shift their focus from front-end fund-accumulation issues to back-end drawdown issues. "We need to see if we can turbo-charge defined-contribution plans to address the weaknesses by looking at annuity options and target-date funds, for example," he says.
The funded status of pension plans at S&P 1,500 companies dropped from 104 percent at year-end 2007 to 75 percent at the end of 2008, according to Mercer, a loss estimated at $469 billion. Mercer warns that the levels of funding needed in 2009 will create a serious drag on corporate earnings.
As employers face higher contributions to restore funding levels, the pressure to abandon traditional pension plans will grow. U.S. employers will be required to contribute more than $108 billion to their pension plans in 2009, according to Watson Wyatt.
Watson Wyatt research indicates that the rate of decline in the number of Fortune 100 companies offering defined-benefit plans slowed after passage of the Pension Protection Act of 2006, which established a more supportive environment for both traditional and hybrid plans. The trend away from traditional defined-benefit plans may accelerate again in this crisis.
As employers increasingly recognize the risks inherent in defined-contribution plans, however, interest in hybrid plans may grow. "Some companies moved to a defined-contribution plan only because of the chaos surrounding hybrid plans," Glickstein says.
"Hybrid plans are now much more viable, and we will see an uptick in the number of companies adopting these plans on the other side of the crisis. We’ll see robust growth."
Much of the growth will come as more companies with traditional pension plans convert to hybrids, but some will come from new plans, Glickstein predicts. "The high-tech industry, for example, has no history of defined-benefit plans, but now the companies have matured and the industry is ripe for new hybrid plans."
The real challenge lies in the regulatory environment. "For years, hybrids were dead on arrival," Glickstein says. "And now, there is no legal framework for phased retirement. The regulatory environment is the biggest obstacle to creating more agile retirement plans."
He says, however, that the impending crisis in Social Security funding may lead to more collaborative discussions between the federal government and employers about retirement programs.
One upside of the economic downturn is that it is likely to spark new thinking about employer-provided retirement benefits, government-sponsored retirement programs and broader workforce management issues.
"Employers have shown an interest in better plan design," Glickstein says. "They are also beginning to acknowledge that 401(k) plans carry financial risks just as pension plans do. It’s been an important ‘Aha!’ moment."
Workforce Management, February 16, 2009, p. 29 -- Subscribe Now!